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Here's Why the Hottest Marijuana Debut of 2019 Is Bad News

Up nearly 400% in two days, this one-of-a-kind cannabis-software company has a great concept, but looks to be a terrible investment.

Marijuana is arguably the hottest investment on Wall Street right now. Although cannabis stocks have underperformed a bit since the beginning of May, their performance, when looked at over the past couple of years, has run circles around broader-market returns.

Within the next decade, the global cannabis industry could be generating north of $50 billion, and perhaps even $75 billion, in annual sales, according to various Wall Street estimates. This means the entire cannabis supply chain, from growers to ancillary players, could make investors a lot of money. And it just so happens that a new type of ancillary player debuted on the Nasdaq last week in a first-of-its-kind listing.

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This is the hottest pot stock on Wall Street right now

One week ago today, MTech Acquisitions, a shell company focused on making acquisitions, and cannabis-software services company MJ Freeway, completed their merger that was first announced in October. Upon completion, the new entity, Akerna(NASDAQ:KERN), began trading on the Nasdaq on Tuesday, June 18. This marked the first time that a cannabis company had listed on the Nasdaq without an initial public offering or an uplisting from the over-the-counter exchange.

Akerna's first day of trading was rather tame, with the company's stock closing at $14.85 a share on just over 120,000 shares traded. But business picked up in a big way on Wednesday and Thursday, with more than 3 million shares traded each day. Akerna's valuation more than tripled on Wednesday to a close of $49.80, then briefly gained another nearly 50% to hit just shy of $73 early Thursday morning before retreating.

What has investors so excited about this newly listed pot stock that they felt it was worth a nearly 400% premium in a matter of two days? The answer lies in the company's business model, which is something investors haven't seen listed on the Nasdaq before.

Akerna's primary focus is on developing software unique to the cannabis industry. In other words, it didn't take software designed for another sector or industry and design it to fit the marijuana model. Rather, the MJ Freeway team has been developing and refining software for around a decade that handles two primary functions for weed businesses: seed-to-sale technology and consulting services.

Image source: Getty Images.

The company's seed-to-sale technology platform is arguably its most valuable. With a number of states requiring airtight oversight on their pot industry, Akerna's software can be utilized to accurately track each and every marijuana plant from when it was a seed to when it's sold in stores. As long as the U.S. federal government classifies cannabis as an illicit substance, thereby disallowing interstate transport of the drug, seed-to-sale tracking will prove very important.

Meanwhile, the company's consulting services primarily focuses on helping marijuana businesses better understand their customers. Akerna's services can be used to improve customer retention, bolster compliance, and even aid with license applications.

All told, Akerna's notes in its filing with the Securities and Exchange Commission that it has clients in 29 of the 33 medical marijuana-legal U.S. states, as well as 11 countries worldwide (including the U.S.).

Sorry, folks, but this high-flying "newbie" is bad news

On the surface, Akerna has a business model that investors can easily rally around. I see plenty of long-term value in seed-to-sale tracking and client services that improve customer retention. Remember, this is an industry that's been dominated by cash due to banks being unwilling to offer basic banking services. Therefore, software that can help dispensaries and growers better understand what consumers want, as well as how to keep them loyal to a brand or business, could prove invaluable.

But this is an instance where I love the business model, but simply don't like the valuation one bit. There are a number of red flags that investors should be aware of before they consider dipping their toes into the hottest cannabis stock on Wall Street.

Image source: Getty Images.

For starters, the company's financials are a bit of an eyesore. Based on the combined company's SEC filing dated May 14, MJ Freeway has generated just $4.97 million in sales through the first six months of its current fiscal year, ended Dec. 31, 2018. That's down -- yes, down -- from the $5.53 million in sales the company recorded during the equivalent time period in the previous year. Not surprisingly, gross profit declined year over year, and net loss rose to just shy of $4 million from $2.9 million. MJ Freeway wound up blaming weaker revenue from Washington State, as well as lumpy consulting service contract revenue, for the dip in year-over-year results.

That brings me to the next point: Akerna is overly reliant on two customers. The company's Leaf Data Systems compliance tracking software (i.e., its seed-to-sale tracking technology) has two clients -- Washington and Pennsylvania -- that accounted for 43% of the company's total sales through the first six months of its current fiscal year. Any change in these contracts could result in a substantial decline in revenue. And it's also worth noting that lumpy government contracts that require Akerna to bid against other software developers will likely represent the company's core source of sales for the foreseeable future.

Another concern is that Akerna's plans for growth involves an "aggressive acquisition strategy," according to Investor's Business Daily. While an aggressive acquisition strategy has worked out OK for marijuana stocks like Aurora Cannabis, it could be problematic for Akerna, which did raise capital with its Nasdaq debut via share sales, but is likely going to need to issue more common stock in order to raise sufficient funds for acquisitions. This suggests that significant share-based dilution awaits shareholders of the company.

Image source: Getty Images.

Last, but not least, the proverbial kiss of death among pot stocks: material weaknesses in internal control over financial reporting. As noted in the company's SEC filing:

MJF [MJ Freeway] had previously identified material weaknesses in its internal control over financial reporting related to controls over its formal documentation and development of its policies and procedures, and the availability of sufficient resources to establish segregated review functions and documentation of financial data.

Akerna has hired a chief financial officer and added to its accounting staff as a means to better improve its internal financial reporting, but this is obviously a big worry given how badly a handful of pot stocks have been hit following a lack of proper internal financial controls.

Again, while I do like the business model, there are simply a laundry list of reasons why this newly listed pot stock should be left out of your portfolio.

Author

A Fool since 2010, and a graduate from UC San Diego with a B.A. in Economics, Sean specializes in the healthcare sector and investment planning. You'll often find him writing about Obamacare, marijuana, drug and device development, Social Security, taxes, retirement issues and general macroeconomic topics of interest. Follow @TMFUltraLong